The tale of a global debt crisis foretold

Anyone who believes that we are now well on the road to a global V-shaped economic recovery has not read the International Monetary Fund’s (IMF) recent gloomy World Economic Outlook. More tellingly, they clearly have not considered how very likely it is that, if the IMF’s depressing world economic outlook is realized, we will have a series of major debt crises in systemically important countries such as Italy and Brazil. 

On the basis of a longer-than-expected pandemic, the IMF now forecasts that the global economy will contract by almost 5 percent in 2020. That would mark the global economy’s worst year since the 1930s Great Depression. It would also represent a much worse economic performance than that in the 2008 Great Recession. 

The IMF is particularly gloomy on the United States’ and Europe’s economic outlooks. For the United States, it now expects that GDP will decline by as much as 8 percent in 2020 before rebounding by 4.5 percent in 2021. It is even gloomier on the European economic outlook. It now expects that the Euro area economies will contract by more than 10 percent in 2020 before bouncing back by some 6 percent in 2021. 

The IMF correctly emphasizes that its economic forecast is subject to more than the usual degree of uncertainty. The world economic outlook would be considerably better if a vaccine or a cure for COVID-19 were soon to be developed. However, the outlook would be appreciably worse if there were to be a second wave of the pandemic or if there were to be debt-related problems associated with the economic downturn. 

In a world drowning in debt, it is this latter risk that must be most troubling to global policymakers. This is especially so at a time when the world is experiencing its worst economic recession in the last 90 years. 

It is not only that on the eve of the coronavirus pandemic, world debt levels were at very high levels. Nor is it only that aggressive budget deficit financing now threatens to raise world debt ratios to above their peak after World War II. Rather, it is that debt has now reached clearly unsustainable levels in systemically important countries such as Italy and Brazil. 

Even before the pandemic chose Italy as its European epicenter, that country had an excessive public debt-to-GDP ratio of 135 percent. In the wake of the pandemic, the IMF now expects that in 2020 Italy’s economy will contract by a staggering 13 percent and its budget deficit will widen to around 10 percent of GDP. That in turn will cause the country’s public debt to skyrocket to an unsustainable 160 percent of GDP by the end of 2020. 

Markets know that Italy’s very poor past economic growth record within the Euro makes it highly improbable that it will ever be able to grow its way out of its debt problem. As investors have started to shun Italian government bonds, the only thing right now keeping that country afloat is the large-scale Italian bond purchases by the European Central Bank (ECB). However, there are political limits to how long the ECB can keep bailing out a member country on the scale at which it is doing in Italy. It would seem that those limits make it only a matter of time before we have a full-blown sovereign debt crisis in a major European economy. 

Brazil is another large country in which we could soon have a debt related economic crisis that could roil global financial markets. This is not least because of the Bolsonaro government’s total state of denial about the seriousness of the COVID-19 pandemic. That state of denial is rapidly transforming Brazil into the global epicenter of the pandemic. It is also seriously undermining the credibility of the Bolsonaro government.

Since the start of the year, the Brazilian currency has lost around 25 percent in its value as both foreign investors and domestic residents have lost trust in the country’s ability to control its public finances. It is not helping matters that Brazil’s public debt-to-GDP ratio now looks set to rise to more than 100 percent, which would be unusually high for an emerging market economy. It will do so as the country’s economy looks set to contract by around 10 percent of GDP in 2020 and as its budget deficit looks set to balloon to 10 percent of GDP. 

Hopefully the world’s economic policymakers do not have their heads in the sand about the risk of a real economic crisis in Italy and Brazil. Otherwise, we should start bracing ourselves for the economic fallout from policymakers once again being caught flatfooted by an external economic shock.   

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.